Construction Bonds Come With Strings Attached. Make Sure You Know What They Are.

When serious trouble befalls a bonded contractor, its surety might be called upon to shoulder significant risk both downstream (i.e., payment obligations to subs & suppliers) and upstream (i.e., performance obligations to the owner, if the bonded contractor is prime, or to the prime, if the bonded contractor is a sub).

Yet even when adversity strikes, sureties don’t expect to suffer a loss, as counter-intuitive as that might sound.  That’s a feature of suretyship distinguishing it from insurance (for a handy, 1-page chart summarizing other distinctions, see page 6 of this 18-page surety primer by CNA Surety).

How do bonding companies seek to avoid losses on troubled construction projects?  One of the most significant weapons in the surety’s loss-avoidance arsenal is the “general indemnity agreement” or GIA, an instrument that virtually every surety requires each bonded contractor, the contractor’s owners and the owners’ spouses to sign as a condition of surety credit extension.  The GIA vests in the surety numerous rights and remedies against the corporate and individual indemnitors, which are typically triggered once trouble starts brewing.

Here are some of the key rights enjoyed by sureties under a typical GIA:

1.  The Right to be Reimbursed.  Most GIAs contain a broad indemnification provision requiring the indemnitors to exonerate, hold harmless and indemnify the surety from and against all liability and all loss, including expenses and attorneys’ fees incurred.  That means, for example, if a surety pays a subcontractor’s payment bond claim, it can then demand contractual indemnification from the bonded contractor, not just for what was paid to the sub, but also for all expenses and costs incurred by the surety in so doing.

2.  The Right to Settle Claims.  Most GIAs allow the surety not only to resolve claims brought against the bonds themselves, but also the affirmative claims of the bonded contractor.  That means, for example, if a surety pays a subcontractor’s payment bond claim, and the bonded contractor has claims for extras against the project owner, the surety has a contractual right to resolve those claims on the contractor’s behalf.

3.  Assignment Rights.  Typical GIAs provide the surety with a contingent assignment of its bonded principal’s interest in contract funds on both bonded and unbonded contracts, with the assignment triggered upon the happening of an “Event of Default,” as defined in the instrument.  Most GIAs I’ve come across define “Events of Default” quite broadly, such that the surety is assigned the bonded contractor’s interest in contract proceeds upon the mere receipt of a payment bond claim.

4.  Right to Act as Attorney-in-Fact.  To give full effect to the other provisions mentioned above, most GIAs give the surety the power to execute all documents required to effectuate its rights on behalf of the bonded contractor.  That means, for example, if a bonded contractor obtains a lien judgment against the project owner, the surety can assign that judgment to itself by executing an Assignment of Judgment instrument on behalf of its principal.

Courts will typically enforce these such provisions in the absence of bad faith by the surety, including North Carolina courts.  In that regard, I commend to your reading the N.C. Court of Appeals’ decision in John Wm. Brown Co., Inc. v. State Employees’ Credit Union.  In that case, the bonded contractor, a GC on a bank branch office building, ran into early trouble arising from a significantly delayed notice to proceed and changed work.  Its performance costs increased, but it waited until the end of the project to seek additional compensation from the owner.  In the interim, subs and suppliers asserted claims against the payment bond that were investigated and satisfied by the surety.

Before litigation commenced, the owner offered the GC $100,000 on its claims.  The GC rejected the offer and filed its complaint.  After a year of discovery, the owner renewed its $100,000 offer.  At that point, the surety, relying upon its GIA with the GC and its owners, exercised its rights and accepted the settlement.  The trial court granted the owner’s motion to approve and enforce the settlement agreement, and the GC appealed.  The Court of Appeals held that the owner was entitled to enforcement of the settlement agreement, citing various provisions of the applicable GIA.  It also ruled that if the GC believed the surety acted in bad faith in resolving the claim, the place to raise that issue was in the indemnity action the surety had asserted against the GC and its owners, not in the action asserted against the owner.

Here’s the takeaway:

• When presented with a GIA for signature, make sure you spend the time to familiarize yourself thoroughly with its provisions.  Each of those terms is likely to be enforced by the courts in the absence of bad faith by the surety.

• When you acquire claims arising from the acts or omissions of the project owner, assert your time extension and/or change order requests timely.  Otherwise, you might run into cash flow problems and require the surety’s assistance later in the project to bail you out, either by paying subs or financing completion.  That, in turn, is likely to result in a complete loss of control over the claims process against the owner.

• Make sure to document your claims well throughout the course of a troubled construction project.  Even if your claim rights get assigned to the surety by virtue of the provisions of your GIA, the surety is less likely to settle upstream claims for pennies-on-the-dollar if those claims are well-supported.

As always, be sure to contact an experienced construction attorney to enhance your understanding of the obligations contained in a GIA.